If you ask bond investors what worries them most today, expect a one-word answer: “liquidity.” But if handled properly, low liquidity can also be an opportunity—as long as you’re selective about the risks you take.

We certainly aren’t trying to minimize investors’ concerns. As we’ve pointed out before, managing liquidity risk is critically important. Asset managers who underestimate it or fail to take precautions run the risk of being forced to sell at a loss when liquidity dries up.

To see what we mean, let’s take a look at the recent sell-off in credit markets. There were several reasons for it: slower emerging-market growth, falling commodity prices and worries about the health of the world economy.

Investors reacted by pulling assets out of mutual funds. Flooded with redemption orders, fund managers had no choice but to sell assets broadly to meet them, even if that meant doing so at a loss. Sell-offs like this can lead to exaggerated moves in the credit market that are out of step with a given security’s probability of default.

Forgetting About Fundamentals

High-yield pharmaceutical bonds, which have taken a beating in recent weeks, are a good example. The sell-off, which shaved as much as 10 points from the prices of many securities, was partly a response to controversy over some companies’ huge overnight drug price increases and proposals to rein in prescription drug costs.

Here’s the thing: While it makes sense that the equities’ of these companies would come under pressure, these developments probably won’t weaken the credit quality of the bonds. The pharmaceutical business is not very capital intensive, which makes them relatively inexpensive to run. That has kept pharmaceutical bonds’ default probabilities low. If anything, more Congressional scrutiny could slow M&A activity in the sector, which would be credit positive.

So why the big sell-off? Again, very few fund managers were in a position to buy, even if they had wanted to. That’s because they had to use what liquidity they did have to meet investor redemptions.

On the other hand, those investors who had built liquidity buffers into their portfolios, buffers such as a global multi-asset strategy and more thoughtful cash management, would have been in a better position to meet redemptions and still seize an opportunity to pick up undervalued assets.

Selectivity Still Required

Widen the lens a bit and you can see that these types of opportunities seem to be everywhere today. After recent sell-offs, valuations across the global credit market look more attractive than they have in years. In some sectors, including US high yield, spreads are at or near levels not seen since 2012 (Display 1).

There are exceptions. For example, European corporate bond valuations don’t look terribly attractive. That’s because the European Central Bank’s bond purchase program has held yield spreads in check.

In most pockets of the market, though, investors are being paid to take credit risk. Still, the key is knowing which risks to take. To us, better valuations don’t justify blindly stretching for the highest yields. It’s too late in the credit cycle for that. Instead, we see this as a selective buying opportunity.

Pay Attention to the Credit Cycle

A closer look at corporate bonds, for instance, shows that opportunities vary across sectors and regions. As Display 2 illustrates, some assets, such as high-yield energy bonds, are in the contraction phase. Their issuers should struggle as long as energy prices remain low and could face more ratings downgrades. So far, the prices of many energy and petroleum companies haven’t fallen far enough to compensate for the risk.

Beyond energy, US high yield is still in expansion mode, though fundamentals for some lower-quality credits have started to weaken. For instance, CCC-rated junk bonds now trade at around 84 cents on the dollar. But we don’t think the low prices make up for these securities’ historically high default rates—44% on a five-year cumulative basis, compared with 23% for B-rated securities and 10% for BB-rated ones.

The key is finding a combination of attractive valuations and solid underlying fundamentals. We think investors are mostly likely to find it in high-quality high-yield bonds and structured securities in the mortgage market, both commercial and residential. Unlike corporates, mortgages are in the earlier stages of the credit cycle and borrowers’ credit profiles are strong.

Worries about the global economy and corporate fundamentals won’t disappear soon. Robust liquidity isn’t coming back, either. That probably means more volatility—and possibly another leg lower in prices. But for investors who focus on fundamentals and keep a close watch on the opportunities low liquidity can provide, it may be time to start adding—modestly and selectively—to risk.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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